Price caps with capacity precommitment Articles uri icon

publication date

  • January 2017

start page

  • 131

end page

  • 158

issue

  • 50

International Standard Serial Number (ISSN)

  • 0167-7187

Electronic International Standard Serial Number (EISSN)

  • 1873-7986

abstract

  • We examine the effectiveness of price caps to regulate imperfectly competitive markets in which the demand is uncertain. To that effect, we study a monopoly that makes irreversible capacity investments ex-ante, and then chooses its output up to capacity upon observing the realization of demand. We show that the optimal price cap must trade off the incentives for capacity investment and capacity withholding, and is above the unit cost of capacity. Moreover, while a price cap provides incentives for capacity investment and mitigates market power, it cannot eliminate inefficiencies. Capacity payments provide a useful complementary instrument.

keywords

  • imperfect competition; demand uncertainty; price cap regulation; capacity investment; capacity withholding; capacity payment; smonopoly